Two cloud infrastructure technologies, OpenStack and OpenShift, are paramount to this narrow-moat company's long-term success.
By Rodney Nelson | 03-27-17 | 08:20 PM | Email Article

After a lumpy third quarter,  Red Hat  righted the ship with strong fourth-quarter results, driven by increased adoption of OpenStack and OpenShift. The company’s emerging technology portfolio continues to grow at an accelerated clip, while Red Hat Enterprise Linux, or RHEL, continues to deliver moderate gains. We are maintaining our narrow moat rating, and after incorporating management’s upbeat fiscal 2018 guidance and rolling our model forward, we are raising our fair value estimate to $91 per share from $84 previously. Shares have rallied roughly 25% from post-3Q lows, and appear close to fair value.

Rodney Nelson is a senior equity analyst for Morningstar.

Fourth-quarter revenue rose 16% versus the prior-year period to $629 million, driven by 40% growth in emerging technologies subscription revenue. RHEL remains Red Hat’s stabilizing force today, as infrastructure-related offerings grew 11% to $435 million, representing 78% of subscription revenue. However, we think emerging cloud technologies represent a crucial opportunity for Red Hat long term, and despite some fits and starts throughout the year, OpenStack and OpenShift were common themes among Red Hat’s largest deals in the quarter.

We think these two cloud infrastructure technologies are paramount to Red Hat’s sustained long-term success beyond RHEL, and we were encouraged to hear several global telecom and financial services firms are beginning to standardize private clouds on Red Hat’s solutions. Since these offerings cover more layers of the stack, we think strong adoption will help to stabilize not only Red Hat’s competitive positioning (as the stickiness of these solutions should be stronger than RHEL alone), but also the firm’s business model, as management believes OpenStack and OpenShift will carry stronger margin profiles than RHEL. To that end, we were encouraged to see management guide to roughly 150 basis points of operating margin expansion in fiscal 2018 as investments in the firm’s salesforce and cloud technology begin bearing fruit.

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